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US Taxes

From the articles of Confederation, March 1st, 1781.
We had the right tax, but the wrong way to implement it:

VIII.

All charges of war, and all other expenses that shall be incurred for the common defense or general welfare, and allowed by the United States in Congress assembled, shall be defrayed out of a common treasury, which shall be supplied by the several States in proportion to the value of all land within each State, granted or surveyed for any person, as such land and the buildings and improvements thereon shall be estimated according to such mode as the United States in Congress assembled, shall from time to time direct and appoint.

The taxes for paying that proportion shall be laid and levied by the authority and direction of the legislatures of the several States within the time agreed upon by the United States in Congress assembled.

I don’t know if this analogy is correct, but I think of US “debt” as equity in the US balance sheet. Yes, it is on the liability side, but it represents the public’s financial ownership position. Just as equity in a firm represents your position on the flows the company generates.

MDM, I also find “government spends by creating bank accounts” isn’t very helpful in explaining MMT. The response is often, “Huh?” It’s just not obvious to most people, who tend to think in metaphors instead of concepts. This is why “printing money” is a powerful expression. They can easily imagine printing presses cranking out dollars, so this is an appealing rhetorical device for people who want to instill fear of inflation while concealing the corresponding risk of rising unemployment as a consequence of such policies. Just think, printing presses running night and day to keep up with the profligate spending!

I have found that the best way to attack this is to emphasize the MMT solution. “Printing money,” “inflation,” Weimar,” Zimbabwe,” and so forth, are all distractions from this, and they often offered as such to divert the debate from real issues. The strong point of MMt is that it shows how to achieve utilization of real output capacity as well as its expansion through investment, which results in full employment in a growing population, along with price stability. This is the point to emphasize, I believe, instead of letting the discussion get sidetracked by objections. Of course, objections have to be met, but in meeting them, one has to advance the debate toward the desired objective instead of getting distracted, which is often an opponent’s strategy.

I don’t think “government spends” is helpful either, since it invites a comparison between government’s currency issuance that take the form of disbursements and private spending based on income. For example, much government currency issuance through disbursement is not “spending” in the ordinary sense. For instance, SS, interest, etc. that don’t involve the government buying anything directly that would count as spending.

What happens is that the Treasury issues currency by crediting nongovernment bank (deposit/demand) accounts in accordance with appropriations. There is no corresponding liability creating in nongovernment, as there is in the case of the creation of bank money through credit extension (loans create deposits). Therefore, government currency issuance results in increased nongovernment net financial assets, whereas credit extension does not. Government deficits correspond to nongovernment surpluses, and vice versa.

Just about everyone has received money from the government, if only in the form of a tax return. It shows up as a check or as a credit on one’s bank account, if one has direct deposit. Anyone can understand this. While the check is physical, the numbers are just digital. Most government disbursements are now digital, that is, marking up spreadsheets. People see this regularly in their bank statements. Those who check online can see these changes made from moment to moment even. These changes represent flows in the economy that show up in the accounting records as numerical changes. Now, a lot of it involves digital scanning instead of manual key strokes.

I think that Warren’s analogy of changing the numbers on a scoreboard is apt. It’s a metaphor that just about everyone is familiar with. Money as a unit of account is just a way of keeping score, so to speak, in the economic “games” involved in exchanging goods and services within government, between government and nongovernment, within nongovernment (domestic and external) and within the private sector (domestic).

The important thing to explain about how the process works “behind the veil” between the Treasury and the Fed is that the Treasury doesn’t “borrow” the funds it spends from the Fed, on which it must pay interest to the bankers. This is a widespread erroneous idea that going viral. The mistake involves confusing accounting liability with financial debt. Not all liabilities are debts, as some erroneously portray.

To understand what happens “behind the veil,” people have to understand bank settlement (clearing), which takes place with reserves, not “dollars.” Reserves are dollars in the sense of unit of account, but they are not the same as the Federal Reserve notes that people call “dollars.” There is no exchange of notes behind the veil. It’s just marking up accounting spreadsheets to balance accounts. Accounting only has real significance at the transaction level.

Reserves are liabilities of the central bank —the Fed in the US. For the Treasury to disburse, the Fed just credits the Treasury’s account with the reserves needed for settlement, e.g., to clear its checks when they are cashed at a bank window or deposited in an account.

These reserves are an asset of the Treasury (on the Treasuries books and in its reserve account at the Fed) that it then transfers to the deposit account of those to whom the funds are being disbursed. This is how currency issuance works. The Treasury doesn’t take out a loan from the Fed, which many people believe to be a private bank, or pay bankers interest on loans.

The central bank is actually an agency of the government, and the currency issued is therefore a liability of the government and an asset of nongovernment. This liability of the government gets extinguished, for example, when nongovernment uses government liabilities (dollars) to meet its own liabilities to the government in the form of taxes, fines and fees.

I have found that a good way to meet the “printing money” objection is to point out that currency is not issued by printing money. Banks exchange reserves for Federal Reserve notes as demanded at the window. The printing press doesn’t create money. The reserves do. This is what the Fed does. No reserves, no dollars.

The trick is ensuring that the right amount of money is created, not too much and not too little. Most people are worried about the government creating too much and sparking inflation, because this is how they are programmed. But ask them what happens if government creates too little money. Then explain that there isn’t enough to buy all the goods and services for sale at full output capacity, so that inventories build up, businesses cut back and fire people. Recession sets in and unemployment rises. Most people don’t consider this side of the story, because they are not told about it.

The government’s prerogative to issue currency carries with it the responsibility to balance spending power with productive capacity so as to achieve full employment along with price stability. Conversely when the Fed targets inflation using unemployment as a tool, bondholders are happy while workers get sacked.

Finally, it is often necessary to counter objections by pointing out that they are based on gold standard thinking which became obsolete on August 15, 1971, when President Nixon shut the gold window and the dollar became a nonconvertible flexible exchange rate currency. This is another of MMT’s strong points. It deals with the actual operation of the international monetary regime now in place.

I think the hardest concept to understand, and which I had trouble accepting too, is that, as Warren puts it – the consolidated government neither has money nor does not have money.

The concept of money is only applicable when we examine the private sector. ‘Money’ or ‘funds’ which exist between the treasury and central bank, are nothing more than ‘internal claims’ akin to (as Wray and Bell have stated) the financial transactions between a husband and wife in a household. Furthermore the internal claims are not measurable monetary variables, in terms of m1, m2, m3 etc.

MDM, the key here is the MMT concept of vertical and horizontal in relation to money creation. This is sometimes called exogenous (outside) and endogenous (inside).

When the government “spends,” the Treasury disburses the funds by crediting bank accounts. Settlement involves transferring reserves from the Treasury’s account at the Fed to the recipient’s bank. The resulting increase in the recipient’s deposit account has no corresponding liability in the banking system. This creation is called “vertical,” or exogenous to the banking system. Since there is no corresponding liability in the banking system, this results in an increase of nongovernment net financial assets.

When banks create money by extending credit (loans create deposits), this occurs completely within the banking system and results in a liability for the bank (the deposit) and a corresponding asset (the loan). The customer has an asset (the deposit) and a corresponding liability (the loan). This nets to zero.

Thus vertical money created by the government affects net financial assets and horizontal money created by banks does not, although its use in the economy as productive capital can increase real assets.

The mistake that is usually made is comparing what happens in the horizontal system with what happens at the level of government accounting. At the horizontal level, debt is the basis for horizontal money creation. Therefore, it is often assumed that debt must be the basis for the creation of money by government currency issuance. This is not the case.

Reserve accounting uses the standard accounting identities, but the meaning of “liability” is not “debt.” The husband-wife analogy for CB-Treasury accounting relationships is apt. Since a husband and wife are responsible for each others debts, neither can be indebted to the other. That is to say, reserve accounting is a fiction that does not represent real relationships, such as exist between a creditor and debtor in the horizontal system.

Moreover, government debt is not true debt either. At the macro level, the reserves that are transferred to banks through government disbursement are used to buy Tsy’s. That is, when a Tsy is bought, this involves a transfer of reserves from the buyer’s bank’s reserve account at the Fed to the government’s account (consolidating CB and Treasury as “government”).

When the Tsy’s are sold or redeemed, the reserves that were “stored” at interest are simply switched back, creating a deposit again. It’s pretty much the same as buying and redeeming a CD. It’s just a switch from demand to time back to demand in a bank account, and a switch between reserves and securities at the government level. That is to say, the government doesn’t have to draw on revenue, borrow, or sell assets to cover its “debt,” as households and firms do. It’s just a matter of crediting and debiting accounts on the (consolidated) government books, even though it may appear that there is a financial relationship occurring between the CB and Treasury due to the accounting. However, it’s just a fiction.

Therefore, the key to understanding MMT is this vertical-horizontal relationship. When one understands this, then Abba Lerner’s principles of functional finance become obvious. (1) Currency issuance through government disbursement is used to increase nongovernment net financial assets, and taxation withdraws net financial assets from nongovernment. (2) Debt issuance by the Treasury is a monetary operation for draining reserves to permit the CB to hit its target rate.

These principles are then applied to Y+C+I+G+NX to balance nominal aggregate demand with real output capacity in order to achieve full capacity utilization, hence, full employment, along with price stability. This is based not on theory requiring assumptions but on operational reality that can be represented using data, standard accounting identities, and stock-flow consistent macro models.

All of this and much more is explained in considerable detail at Bill Mitchell’s billy blog.

Even with our current system of taxing realized capital gains, if you lose money in one year, you can carry forward the loss to future years’ tax payments. I glanced at the Laffer-Moore book this weekend at a bookstore. They averaged capital gains over a rolling 5 year period. If a steady revenue stream for government is the goal, that’s swell but if the idea is to withdraw reserves from the economy during boom times but keep money in the private sector during downturns, I suppose its better if its calculated year to year.

Over the years, there have been several proposals for taxing unrealized capital gains, so its often been noted the advantage is it eliminates the lock-in problem as surely as a zero tax on cap gains, the disadvantage is as you identify– what about the wealth rich, cash poor? One, I don’t think there’s any fair way to to immediately tax the total unrealized capital gains on a long-held investment (the cap gains from past years then wouldn’t be hit until sale). From the first year and thereafter, it would have to be done by filing a return on the increase in total net worth from Jan. 31 to Dec. 31 for that tax year (presumably, the IRS could tax either total, real estate only or non-real estate only wealth). Two, there should be some large income threshold ($100,000, $500,000, $1 million) before unrealized cap gains are recognized as income. Considering that the top 20% of households controls 85% of total net worth (for real estate, I’ll note, it’d count property value minus mortgage), this would exempt most people who’d have difficulty paying on their property holdings without losing much revenue.

Finally, for those who still owe taxes but might still have difficulty making payments, economist William Vickrey suggested that the IRS do as some states allow elderly property taxpayer to do– defer tax payment but take a lien on the property. When its sold, the accrued tax liens (which may have an interest penalty) are paid off first. Its always tricky to change long standing tax rules. On the plus side, there’d be more than enough money raised (by an order of magnitude) to permanently eliminate estate taxes.

MDM, google Randy Wray’s column last fall advocating that the US not increase its debt limit and simply have Tsy overdraft its Fed account, he discusses some of the issues you raise.

Perhaps I need a more dumbed down version or some counter arguments. When I preset the Chartalist case I go through the following argument structure:
1. Taxes create demand for government currency.
2. Bonds are an interest-rate operation
3. Governments spend by crediting bank accounts.

One is a bit iffy, but generally when going through the various supporting arguments, followed by a “why else do people use government currency”, I can get a slight agreement. Point two is generally fine, as I explain it through the balance sheet approach. But I can never seem to get point 3 across.

I try and explain it as follows:
The treasury has an account with the central bank. When it spends it credits bank accounts, and the central bank draws down on the treasury’s main account. The central bank credits the accounts of the various banks whose deposits increase as a direct result of government spending (i.e. accounts in the respective banks have been targeted). From this point on, they usually object that this is printing money, or that the treasury will need to pay back the central bank. I generally accept the first point, that whenever government spending exceeds the inflow of tax revenue, that money is created. On the second point I state that the loan is nothing but an internal claim and exists outside the definition of money and that all central bank profit needs to be returned to the treasury each year. At this point, they may be slightly convinced or they just outright reject it and the conversation fails to go any further. Any thoughts?

How do people usually bring up the Chartalist points and what arguments do they make to objections raised. Perhaps there needs to be FAQ or wiki with a counter argument to the various objections raised towards Chartalism.

I’ve also got the following questions:
1. When the central bank returns the profit to the treasury, what does this the actual profit?
2. Scott Fullwiler (2007, p. 1018) states that the self imposed constraints upon government spending “can be and have been repeatedly sidestepped when it has been deemed desirable to do so”. What exactly happens in this situation? Is the treasury’s main account reduced to negative, or is another account made to supplement the main account?
3. Is currency a liability on both the treasury’s and central bank’s balance sheet? I can understand the latter, but from several RBA papers I have read, they speak of the Treasury’s ‘core account’ as having ‘funds’? Does this just go back to the original point that these are only an internal claim?

it might be helpful to first let people know when you say govt you are talking about the fed and tsy as all part of the same gov, and what they do with each other is something like you moving money from one pocket to another, and can be ignored.

then you can say that operationally, when govt spends it just changes numbers up in our bank accounts.

and you can watch it happen with on line banking. if you have 3,000 in your account you see that number on your screen. and when your 2,000 social security payment comes in all the govt does is change your 3 into a 5. Just like when you knock down 5 pins while bowling and the bowling alley changes your score from 10 to 15. No one wonders where those points come from.

I’ll try that next time. To be honest, consolidating the treasury and the central bank has always been a point that I have been sceptical on. I’ve accepted it, uneasily, but I have never understood the reasoning why and it’s been something that I have been looking into.

Reading: Wray and Bell, 2003 “Fiscal effects on reserves and the independence of the Fed” has helped clarify the point. As I understand it, one of the reasons the treasury and the central bank are seen as consolidated because they are viewed from the private sector, the ‘outside’ so to speak. ‘funds’ on the treasury’s account at its central bank are nothing more than internal claims, similar to transactions and ‘claims’ between a husband and wife. Furthermore they are not a measurable variable in the sense of m1,m2,m3 in that they have no impact upon the private sector.

I think that this may be the hardest part to accept and it seems to be the main point of criticism, that I have read, in the literature.

off topic:
Warren you’ll be pleased to know that there are a growing group of students (myself included) are accepting MMT. I recently had to do a presentation on the topic of government finance and debt and I used to opportunity to present the MMT case, needless to say, it sparked a lot of interest and there are several students who are pursuing mmt further and questioning a lot of what has been taught.

Questions on the unrealized capital gains tax… What happens circa 2008-2009 when your unrealized gains suddenly become unrealized losses? Will you get a big refund check in the mail from the IRS? If so, will checks be going back and forth between you and the IRS every year? In addition, where/how do you raise the funds to pay for your unrealized gains? Wouldn’t that mean at the end of every up year in the stock market for instance, billions of shares need to be sold to pay for the taxes on unrealized gains?

Yeah, how that tax regime worked out for Uncle Sam can best be summed up by the title of the Calvin Johnson book on the subject, “Righteous Anger of the Wicked States is a history of why the U.S. Constitution was adopted. The most pressing need was to allow the federal government to tax to pay off the debts of the common defense”.http://www.utexas.edu/law/faculty/calvinjohnson/RighteousAnger/

Somewhat related, I see Arthur Laffer and Stephen Moore have a flat tax proposal in their new book that includes taxing unrealized capital gains, which is as as close we can get to a federal property tax under our Constitution.

Some of their arguments will even surprise the crowd who think supply side theory is simply an apology for the wealthy. Laffer and Moore suggest the US abandon its current tax code in favor of a flat tax on income with almost no deductions. They do make an exception for mortgage interest, but that is about it.They even suggest taxing unrealized capital gains yearly, a modification that would do more to “soak the rich” than even the most extreme demands for a tax increase on “those making more than $250,000.” The bill for Warren Buffet alone would run into the billions.

Let’s see, household total net worth increased last year by 2.8 trillion to $54 trillion, so a 15% tax on capital gains (realized or unrealized) would bring in $420 billion– about half of what the regressive FICA payroll taxes bring in. One thing about taxing capital gains– its one hell of an automatic stabilizer, people would still be using their capital loss deductions from 2008.http://mjperry.blogspot.com/2010/03/2009-household-net-worth-increased-by.html